Long Call Butterfly Direction: Sideways

Strategy Description

Long Call Butterfly is one of the sideway strategies
employed in a low volatile stock. It usually involves buying one lower
strike (In The Money) call, selling two middle strike (At The Money)
call and buying one higher strike (Out of The Money) call options of the
same expiration date. Typically the distance between each strike prices
are equal for this strategy.

Limited to the amount of Net Premium Paid for the call options (May loss 100% of amount invested in this option trading strategy)

Maximum Reward :

Limited to the different in adjacent
strikes less net premium paid when the stock is at the middle strike
price (at expiration).

Breakeven :

Upside Breakeven = Higher Strike less Net Premium Paid

Downside Breakeven = Lower Strike add Net Premium Paid.

Net Position:

This is typically a net debit trade even though the cost is normally relatively low.

Advantages and Disadvantages

Advantages:

Ability to make profit from a range bound stock with relatively lower cost outlay.

Limited risk exposure compare to Short Straddle strategy when the underlying stock moved beyond the breakeven point on expiration date.

Disadvantages:

The profit potential only come from the narrow range between the 2 wing strikes.

Bid/Ask spread from the various option legs may adversely affect the profit potential of the strategy.

Exiting the Trade

Offset the position by buying back the call options
that you sold and selling the options that you have bought in the first
place.

As the underlying stock fluctuate up and down, advance option
traders may choose to unravel the spread leg by leg. In this way, the
trader will leave one leg of the spread exposed while he profit from the
closure of the other legs.

Long Call Butterfly Example

Assumption: XYZ is trading at $59.40 a share on Mar 20X1.
You are expecting share price of XYZ to fluctuate back and forth within a
range after the recent quarterly earning announcement. You would like
to profit from the low volatility of this stock but with limited risk
exposure.

In this case, you may consider to buy one Apr 20X1 $55 strike
call at $5.60, sell two Apr 20X1 $60 strike call at $2.40 and buy one
Apr 20X1 $65 strike call at $0.70 to profit from the low volatility
outlook of the stock. Note: commissions are NOT taken into account in the calculation.

A Long Call Butterfly consists of three equally spaced
strike prices. It gets the name from the shape of its profit and loss
graph at expiration. The 2 outside strike are commonly referred to as
the wing, whereas the 2 middle strikes are commonly referred to as the
body. It is a four–legged spread option strategy consisting of all calls
and is the opposite of Short Call Butterfly, which is a volatility strategy.

Before you executed this strategy, you must first determine at which price you believe the underlying stock most probably will be trading
at the expiration date. This will be strike price (middle) where you
will sell the two middle strike options. Next buy a lower strike option
and a higher strike option with equal distance from the middle strike
sold to limit the risk exposed.

Try to ensure that the stock is trading range bound and identify
clear areas of strong support and resistance. The stock is also
anticipated to consolidate (become less volatile) and trading sideway
for the duration of your trade.

Time decay is generally helpful in this strategy when it is profitable and harmful when it is in a loss position.

When you enter the trade, the stock price will typically be in the profitable area of the risk profile.

Therefore
it is preferably to use this option trading strategy with around 1
month left to expiration so as to give yourself less time to be wrong.

You may also execute the Long Butterfly strategy using all puts
options. When all puts options are used, it is referred to as the Long Put Butterfly strategy. The characteristics of a Long Put Butterfly are the same as a Long Call Butterfly.
As to whether a butterfly strategy should be executed using all calls
or all put options depend on the relative price of the option. The
premium of both puts and calls option should be taken into consideration
to achieve the optimum trade.

You should pick the strike price and time frame of the Long Call Butterfly according to your risk/reward tolerance and forecast outlook of the underlying stock. Having the patient to wait, knowledge to apply and discipline to follow through the option trading strategies with appropriate risk-reward parameters is important to your long term success in option trading.